Ever have a glitch when it comes to budgeting and wind up in overdraft or close to it?
Whether it’s from an unexpected transaction, forgetting about an automated bill pay, or just overspending, there are times when checking accounts may dip dangerously low.
In these situations, a cash cushion can add a layer of protection. It’s a bit of extra money kept in your account to help protect against bounced checks and overdraft charges.
Read on to learn more about cash cushions, including:
• What is a cash cushion and how does a cash cushion work?
• Why are cash cushions useful?
• How can you save up a cash cushion?
• What are the differences between a cash cushion vs. an emergency fund?
• What are alternatives to cash cushions and emergency funds?
What Is a Cash Cushion?
A cash cushion is extra money in a person’s checking account that serves as a buffer. It can keep them from hitting zero or overdrawing if they deviate from their budget or a minor emergency occurs.
As you may know, if you overdraw your checking account, you can owe overdraft or NSF (non-sufficient fund) fees and possibly be liable for other late charges as well. With a cash cushion in place, you may avoid the risk of overdrawing and these consequences.
How Do Cash Cushions Work?
Even if you’re the most meticulous budgeter, you can benefit from keeping a cash cushion in your checking account. Here’s how it can help: Say it’s the first of the month when rent and other bills auto-withdraw from a checking account. Maybe you made an error in your math or you swiped your debit card a few too many times, and there isn’t enough in your account to cover those bills. This would usually mean that your account would be overdrawn, leading to fees and canceled transactions.
But, if you keep a cash cushion of even a couple of hundred bucks in the checking account, it can prevent the account from becoming overdrawn. It can also take the stress off of having a perfectly balanced budget all the time. Having some extra cash sitting there, just in case, can really pay off.
Worth noting: A cash cushion is different from a slush fund, another odd financial term. What is a slush fund? It’s typically someone’s “fun money” in a budget, or cash set aside for discretionary spending.
Reasons Why a Cash Cushion Is Useful
A cash cushion is useful for several reasons:
• It creates breathing room. Instead of keeping the exact amount of money needed monthly in a checking account, the cash cushion creates padding in the event of a budget mistake or emergency expense.
• It benefits “hands-off budgeters.” Some account holders may set their budget at the beginning of the month and then not check in again that often. A cash cushion can provide peace of mind in this scenario.
• It can help avoid account fees. A cash cushion helps avoid overdrawing a checking account. The average overdraft fee is $35, which can add up over time.
Tips for Saving Up a Cash Cushion
While a cash cushion can sound intimidating, it likely only amounts to a few extra hundred dollars, $1,000 at most, in a checking account. In terms of financial priorities, it’s lower on the list than necessities, or building up an emergency budget.
Here are a couple tricks for starting a cash cushion:
• Reserve just a few dollars each paycheck until reaching the goal.
• Set aside a windfall, like a quarterly bonus or tax refund.
• Cut out an unnecessary expense, such as a streaming service, for a few months.
• Reward good behavior. Pay a bill on time? Add a dollar to the cash cushion budget. Visit the gym? Add a dollar to the cushion.
• Adopt “no spend” days and put the cash that would’ve been spent into the cushion budget.
Recommended: What Is a Sinking Fund?
Is This the Same as an Emergency Fund?
An emergency fund is used to cover large, unanticipated expenses. This could be anything from a medical emergency to living expenses in the event of losing a job. While it’s impossible to anticipate when things will go wrong, an emergency budget can help people avoid going into debt when a financial emergency happens.
Emergency budgets can be a sizable chunk of change. It’s recommended to reserve between three to six months’ worth of living expenses in a separate savings account.
How Do Emergency Funds Work?
If everything goes well, an emergency fund isn’t deployed. But, if a large, urgent bill hits, this fund can help cover the costs. Without an emergency fund, it might be challenging or impossible to pay this expense without taking on credit card debt or asking for assistance.
Emergency funds should be easy to access. While the fund probably shouldn’t sit in an everyday checking account, where it earns little or no interest, it also shouldn’t be in the market or a retirement fund, where it would be challenging to withdraw. Many choose to start an emergency fund in its own standard or high yield savings account, where it can accrue interest.
Recommended: Why Emergency Funds are so Important
Reasons Why an Emergency Fund Is Useful
When things are going well, it might be hard to imagine why an emergency fund is useful. No one ever really expects accidents to happen, for instance, but they do. So consider these benefits that underscore the importance of having an emergency fund:
• It helps avoid debt. Without an emergency fund, the path to paying bills may involve resorting to credit card debt, unsecured loans, or pulling from retirement to pay expenses.
• It can provide a cushion during unemployment. Unemployment benefits might not be enough to cover day-to-day living expenses in the event of job loss.
• It could relieve stress. An emergency may happen, but money set aside could provide a sense of financial security.
Tips for Building an Emergency Fund
Accruing three to six months’ worth of living expenses may sound challenging, but the cash doesn’t have to be saved all at once. Consider these strategies when building a beginner emergency fund:
• Automate transfers, even a few bucks a week, from checking to your emergency fund account.
• Look for excess spending, such as a pricey gym membership or multiple streaming services. Cancel those, and put the savings towards your fund.
• Take on a side hustle to earn extra money, at least temporarily, until reaching the goal.
• Challenge yourself. Skip eating out for a month, and send the savings to an emergency fund.
• Sell any gently used items you own (clothing or electronics, say), and put the proceeds towards your fund.
Cash Cushion vs Emergency Fund
At a high level, cash cushions and emergency funds seem very similar. They are both techniques that provide a financial safety net. However, an emergency fund is usually larger than a cash cushion because it’s designed to cover the possibility of a greater expense. Also, an emergency fund is typically held in a savings account, while a cash cushion stays in your checking account.
Here’s more detail on how each works and how they compare:
|A separate savings account
|$300-$500, perhaps $1,000
|Three to six months’ worth of living expenses
|A buffer to avoid overdraft or NSF fees
|Cash to cover large, unexpected expenses
How Emergency Funds and Cash Cushions Can Improve Your Banking Experience
Both cash cushions and emergency funds can make banking simpler and better.
Cash cushions can help keep unwanted fees, like overdraft or NSF fees, at bay. This saves the account holder money and stress.
An emergency fund can bring in interest since it’s usually held in a savings account. In this way, it builds a bit of additional money.
Alternatives to Cash Cushions and Emergency Funds
There are a couple of alternatives to cash cushions and emergency funds.
In the case of a cash cushion, you might instead opt for overdraft coverage by linking a backup savings account to your checking account. If your checking account is about to be overdrawn, money is whisked in from your savings to cover the shortfall.
If an emergency strikes and you don’t have a fund waiting, there are a couple of other sources of cash:
• If you have a Roth IRA (individual retirement account), you might be able to withdraw funds without penalty. However, once you’ve tapped retirement savings, it can be hard to rebuild them.
• You might be able to use an HSA (health savings account), if you have one, to pay for unexpected health-related costs.
• A HELOC (home equity line of credit) might be an option if you are a home-owner. This line of credit can be a source of cash, but you will need to pay it back plus interest.
• Credit cards are an option if you are hit with unanticipated expenses, but they carry high interest rates. Most financial experts recommend using these sparingly as debt can snowball.
Banking With SoFi
A cash cushion can help account holders avoid overdrawing their checking and paying fees. This “breathing room” (usually a few hundred dollars sitting in their account) can allow them to worry less about their balance on a daily basis, knowing they have some wiggle room.
Looking to build a cash cushion? Consider opening an online bank account with SoFi. If you sign up for Checking and Savings with direct deposit, you’ll earn a competitive APY, plus you’ll pay no account fees. That means your cash cushion could grow that much faster.
Is a cash cushion different from an emergency fund?
Yes. A cash cushion is padding (typically a few or several hundred dollars) that someone keeps in their checking account to fill in small gaps in overspending. An emergency fund, however, is usually a larger sum of money, held in a savings account, and reserved for unexpected expenses that come up, such as a medical emergency or paying expenses when out of work.
Should a cash cushion be the same amount as an emergency fund?
No. A cash cushion can be a couple hundred dollars, or up to $1,000, while an emergency budget should cover between three and six months’ worth of expenses.
Should I keep my emergency fund and cash cushion in separate accounts?
Yes. Emergency funds should be in their own savings account, while a cash cushion should be in a regularly used checking account.
Photo credit: iStock/Mykola Sosiukin
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